How much risk are you willing to take when it comes to investing? The answer is your risk tolerance level, one of the biggest considerations when building a comprehensive financial plan, and we’re here to help you understand how you can determine yours.
What Is Risk Tolerance?
Simply put, risk tolerance is the amount of market risk you’re willing and financially able to take on. Investors are usually grouped into three categories based on their ideal level of risk, which is determined by a wide range of factors.
Conservative investors are willing to accept little to no risk. They go for the safest investing options and are more concerned about avoiding losses than making gains.
Moderate risk investors follow a “balanced” strategy and invest in both risky and safe asset classes. Compared to aggressive investors, they earn less when the market does well but don’t experience as much loss when it falls.
Aggressive investors, those with a high risk tolerance, are willing to risk losing money for potentially superior returns. These investors prioritize capital appreciation and are typically well-versed in the market.
What Factors Determine Your Risk Tolerance?
GOALS
Not everyone has the goal of accumulating as much money as possible. An investor, often with the help of a financial advisor, decides how much money is required to reach a specific goal and then develops an investment strategy that will deliver the needed returns. This means every investor will take on a different risk tolerance level according to their objectives.
AGE
In general, younger individuals are able to take on more risk because they have more time to handle market fluctuations. However, age shouldn’t be seen as a sole determinant of risk tolerance. A young individual may have short-term goals that would make them less tolerant to risk, such as saving for a house down payment.
TIME HORIZON
The short-term goal of saving up for a down payment is an example of an investor’s time horizon, the amount of time they’re able to go without needing their investment amount back. Investors with a long time horizon typically have a higher risk tolerance since market changes don’t have much impact on returns in the long run.
Investors with a short time horizon, on the other hand, usually have a low risk tolerance because market volatilities carry more weight over short periods of time.
INCOME
For similar reasons, an investor’s risk tolerance can vary depending on their disposable income. The higher their income, the higher their risk tolerance tends to be. This is because more income means more financial cushion in the case of market volatilities.
PAST BEHAVIOR
While an investor may be able to take on risk, they might not react well to it. For instance, when markets took a turn for the worse back in 2020, were you quick to sell investments? Or did you hang on through the rough times, perhaps even investing more? Your reactions to past market volatility are a good indicator of how you handle risk.
How Is Risk Tolerance Determined?
When you join us at Ironwood Wealth Management, we have you take a 25-question questionnaire designed to help us assess your willingness to take risk. In addition to your survey answers, we take into account all of the factors discussed above to arrive at an objective risk assessment.
From there, we help you align your risk tolerance with your actual investments, making changes whenever appropriate, so you always stay on track to achieve your objectives.
Why Apply Risk Tolerance to Financial Planning?
Investors often think they’ll be able to remain rational as the market dips and peaks, but the truth is actually the opposite. It’s easy to become overly emotional when the market falls and start panic-selling—which almost always ends badly. With a clear understanding of how you truly react to market fluctuations, you’re able to develop a practical financial plan and make sound financial decisions that help you achieve the milestones you set out for yourself.
If you’re ready to understand your risk tolerance and reach your financial goals, we’re ready to help you get there with our holistic financial planning and portfolio management services. Contact us today to learn more about our approach.
